Note: Use a stop order to trigger a market or limit order once a specified price has been reached. A stop order is appropriate when it is important to confirm the direction of the market before entering a trade.

A stop order to buy or sell becomes active only after a specified price level has been reached (the "stop level"). Stop orders work in the opposite direction of limit orders: a buy stop order is placed above the market, and a sell stop order is placed below the market (see Figure 4). Once the stop level has been reached, the order is automatically converted to a market or limit order (depending on the type of order that is specified). In this sense, a stop order acts as a trigger for the market or limit order.

Consequently, stop orders are further defined as stop-market or stop-limit orders: a stop-market order sends a market order to the market once the stop level has been reached; a stop-limit order sends a limit order. Stop-market orders are perhaps the most commonly used since they are typically filled more consistently.

Figure 4 - A buy stop order is placed above the market; a sell stop order is placed below the market. Image created with TradeStation.

Since a buy stop order creates an order to purchase a stock (or other trading instrument) above the current price, some traders may wonder why anyone would want to enter a trade at a worse price than the current market price. This is a good question. A buy-stop order will trigger the market or limit order only if price reaches the stop level, allowing traders to challenge price to reach a certain level. If price reaches the stop level, it can provide confirmation regarding the direction of the market. Traders often use key levels, such as support and resistance or Fibonacci levels, when choosing stop levels. Figure 5 shows a buy stop market order that will fill once price touches the $1425 price level on the e-mini S&P 500 futures contract.

Figure 5 - This buy stop order will trigger a market order and enter a long trade once price advances to $1425.00. The current price ($1423.50) appears in the yellow-shaded price cell. Image created with TradeStation.

Perhaps the most common use of a stop order is to set a risk limit for a trade, or a stop-loss. A stop-loss order is set at the price level beyond which a trader would not be willing to risk any more money on the trade. For long positions, the initial stop-loss is set below the trade entry, providing protection in the event that the market drops. For short positions, the initial stop-loss is set above the trade entry in case the market rises.

Another application of a stop order is the trailing stop. A trailing stop is a dynamic stop order that follows price in order to lock in profits. A trailing stop incrementally increases in a long trade, following price as it climbs higher. In a short trade, a trailing stop decreases as it follows price downward. Traders must define the magnitude of the trailing stop, as either a percentage or a dollar amount, defining the distance between the current price and the trailing stop level. The tighter the trailing stop, the more closely it will follow price. Conversely, a wide trailing stop will give the trade more room, as it will be further from price.

Next: Introduction To Order Types: Conditional Orders »



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